Sunday, December 23, 2012

After the Affordable Care Act? After Obamacare? Part Two: Supply and Competition

In reviewing part one, John Cochrane professor of finance at the University of Chicago Booth School of Business wrote a recent essay entitled After ACA: Freeing the market for health care. The essay is very interesting as it makes the case of the need for decoupling health care from health insurance when discussing the demand and supply for health care and insurance merely being a mechanism to address catastrophic losses. Others have also pointed out the need to decouple the two concepts, however Cochrane does so in such a way that points out that the supposed market failure in health care is directly related to government failure in the realm of health care due to government lead market distortions on both the demand and supply side of health care.

Supply and competition is now examined. Cochrane uses several examples of firms in sectors other than health care that have pushed the cost, innovation and quality frontier “out to its limits, and then discovering where people really want to be”. That is, what does the consumer value and atwhat price and hence what part of the cost, innovation and quality frontier creates maximum utility. Further, the cost, innovation and quality frontier has been pushed out to “choosing a different point on a far better frontier than we faced 20 years ago.” (1)

Problem is, the cost, innovation and quality frontier in health care is not reacting to generate what the consumer values and at what price and hence what part of the cost,innovation and quality frontier creates maximum utility for the consumer. Why? Cochrane’s explanation is very public choice theory oriented: old status quo suppliers within the health care sector are protected by government regulation and new competitors have massive barriers to entry and hence the protected firms merely collect rents with little incentive to find what part of the cost, innovation and quality frontier creates maximum utility for the consumer.

In order to change the situation, Cochrane states:

"How will this change come about? My examples share a common thread: Intense competition by new entrants, who put old companies out of business or force unwelcome and disruptive changes. Microsoft displaced IBM, and Google is displacing Microsoft. Walmart displaced Sears, and Amazon.com may displace Wal-Mart. Typewriter companies didn’t invent the world processor, nor did they adapt. The post office didn’t invent FedEx or email. Kodak is out of business. Toyota gave us cheaper and better cars, not Ford/GM/Chrysler competition. When the older businesses survive, it is only the pressure from new entrants that forces them to adapt.

My examples share another common thread. They remind us how painful the cost control, efficiency, and innovation processes are. When airlines were regulated, artificially high prices didn’t primarily go to stockholders. They went to unionized pilots, flight attendants and mechanics. Protection for domestic car makers supported generous union contracts and inefficient work rules, more than outsize profits. A look at a modern hospital and its supply network reveals lots of similar structures. “Bending down cost curves” in these examples required cleaning out these rents, through offshoring, elimination of union contracts and work rules, mechanization, pressure on suppliers, and internal restructurings.

The fact that so much cost reduction comes from new entrants, not reform at the old companies, is testament to the painfulness of this process, and the ability of incumbents to protect the status quo.” (2)

Cochrane is correct that the process which is very akin to Schumpeter’s creative destruction is by no means painless. However, it’s totally painless to status quo old firm protected by government regulation that merely pass on higher and higher prices with little or no interest in finding what part of the cost, innovation and quality frontier creates maximum utility for the consumer.

Finally, Cochrane makes an excellent point if government regulation was removed protecting old firms and allowing new competitors to enter the market at will: “The fear, so often expressed in medical contexts, that unregulated competitive suppliers will pawnpawn off shoddy merchandise on consumers seems exactly false.” Cochrane is correct. The argument is merely the argument put forward by the old firm collecting rents under the protection of government regulation. The same argument has been put forward many times by old firms in protected industries. It is by no means a new argument. His point is very correct and he points to examples such as Toyota dislodging the Big Three Auto makes was not done by selling shoddy products. Nor did Southwest airlines gain market share from United and American by selling shoddy product/service. Rather, Toyota and Southwest actually exposed the shoddy product/services of the old firms. (3)

Notes:

(1) After ACA: Freeing the market for health care, John Cochrane, 10/18/2012.

About Me

BS Economics, cum laude, Private and Public Sectors, 1979, West Virginia University, Morgantown, WV.
Undergraduate Minor in General Insurance.
Chartered Life Underwriter (CLU), Huebner School of Economics, American College, 1992, Bryn Mawr, PA.
Life Underwriter Training Fellow (LUTCF), 1986, National Association of Life Underwriters, Washington D.C..
Currently enrolled and completed one half of Chartered Property and Casualty Underwriter (CPCU) from the American College.
38 years insurance industry experience.